Sovereign debt’s grave new world

Bonds have been the saviour for institutional investors in the global recovery, but a new bout of risk-aversion induced by concerns about sovereign risk threatens the stability of the traditionally defensive assets.

Risk aversion has become a clear trend in recent weeks and caused US 10-year Treasury Bills to close at the end of June with a yield of 2.93 per cent – the lowest rate in more than a year – while two-year bonds closed at 0.6 per cent, their lowest yield in history, even those following the collapse of Lehman Brothers, notes Kapstream, a fixed-income boutique, in a recent research note.

“Similar to what happened during the crisis, market psychology is currently driven by the adage: return of capital is more important than return on capital,” Kapstream writes.

This flight from risk is broadly being driven by worries about sovereign risk, the impact of austerity measures and funding stress of many European banks. And while these measures aim to remedy Europe’s fiscal problems, they are expected to destroy growth in the process.

Investors are weary of the bad news. “Market fatigue seems to have set in. While cutting rates to zero combined with quantitative and fiscal easing created a short-term resolution, the market looks to be poised for another setback unless additional stimulus is added,” the manager writes.

But Kapstream believes the likelihood of a double-dip recession is unlikely unless a major catalyst – a sovereign default or another large drop in US housing – rocks the financial world. However the risks affecting markets now are the most severe since the recovery began.

And they permeate the traditional safe harbour of institutional portfolios. Kapstream believes the current upside in holding G7 government debt is limited. The rally in these assets in the past few months has been driven largely by fear, and bond yields now fully reflect a slowdown in economic growth over the next year.

Referring to a GMO history of 10-year Treasury Bill performance from 1971 to 2010, the manager pointed out that bonds with a nominal return of 2.8 per cent, which is less than than today’s yield, delivered a real return barely above zero.

PIMCO, the world’s largest bond manager, believes that policy risk has emerged as one of the headline risk factors in the ‘new normal’ environment that the recovery has brought us into. Policy risk impacts markets when the hand of government directly influences financial markets. The debt bailout package for Greece, at about $927 billion, was the latest major fiscal stimulus handed down by Western governments since the financial crisis broke in September 2008.

In the ‘new normal’, characterised by the continuing strong economic growth in major emerging economies and a slowdown in the developed world, the US will still be a dynamic economy and the dollar will remain the world’s reserve currency, PIMCO notes. But it is battling structural problems such as high debt in government and households, and political polarisation.

Kapstream points out that 46 of the 50 states are likely to experience budget shortfalls amounting to $112 billion for the current financial year. By far, California is in the worst shape: it bears an unemployment rate exceeding 12 per cent and its $19 billion budget deficit is more than those of Greece, Portugal, Ireland, Hungary and Romania combined, the manager writes.

The US will also remain the pre-eminent ‘safe haven’ for bond investors, and for this reason PIMCO recommends that investors direct their interest rate exposures toward the US, and seek diversification in countries with sound fiscal conditions, notably Germany, Canada and Brazil, and the sovereign debt of well-performing emerging markets such as Mexico, Korea and Russia, which have low levels of debt relative to the size of their economies.

It also recommends a modest currency exposure to countries with solid fiscal conditions and banking systems, such as Australia, Brazil and Canada.

It’s becoming clear that emerging market debt will play a bigger role in defensive portfolios in the years ahead.